How Paying Off Delinquent Debts Can Increase Your Credit Score

One of the most common questions I get from consumers is whether or not paying or settling defaulted debts will improve their credit reports and credit scores. Normally, this question applies to charged-off credit cards, deficiency balances on auto loans after repossession, unpaid collections, tax liens, and defaulted student loans. Each of those liabilities can be paid off after the fact or the balance can be exhausted via an offer in compromise (i.e. a settlement).

Once the item has been paid or settled the next step is to ensure that it is reflected accordingly on your credit reports. In a perfect credit reporting world, the account would be updated within 30 days to show the new balance. However, we don’t live in a perfect credit reporting world. As such, it might be necessary to dispute the item with the credit bureaus so that they can do their research, find that it has been paid, and update your credit reports. All in, this process will likely only take a few weeks.

Now that the item has been updated, your credit scores should improve, right? It’s not that simple. Credit scores care much less about the balances on your delinquent accounts than they do about the fact that the account went delinquent in the first place. The incident is what matters—not the balance of the incident.

Credit risk scores are designed to predict the likelihood of you missing payments over some predetermined period of time. In the FICO credit scoring system, that period of time is two years. Meaning? Whenever your FICO score is pulled by a lender, they’re getting a read on whether or not you’ll go 90 days delinquent—or worse—on any credit obligation in the following 24 months. That is what’s referred to as a credit scoring model’s “performance definition” or its stated design objective.

You probably noticed that we don’t talk about the balance balance in that design objective. FICO scores are not built to predict the balances on your defaults. They’re simply built to predict whether or not you’re likely to miss payments, in any amount.

A collection incident with a $1,000 balance is just as damaging as a collection incident with a $2,000 balance. A collection incident with a $0 balance is just as damaging as one with a balance greater than $0.

This may seem like an incentive to not pay off your delinquent debts. Not so fast. Delinquent debts often lead to collection lawsuits, default judgments and even wage garnishments. Settling or paying the debt prevents those things from happening.

There are all sorts of myths about how paying off defaulted debts can result in their removal from a credit report. The problem is they’re just that, myths. The credit reporting agencies make it clear in their agreements—and in their credit reporting guide—that derogatory accounts are not to be removed simply because they’ve been paid. Their instructions are to update the account to show a $0 balance and leave it on the credit report.

There are, of course, examples where collectors or creditors do remove paid delinquencies. Don’t be fooled: That’s not the norm. If the delinquent item is removed, you could see a bump in your credit scores, but even that’s not guaranteed. If you’re successful in removing one or two of several derogatory credit entries, you likely won’t see a major score improvement.

Remember, nothing on a credit report has a specific value in your credit scores. Inquiries are not worth five points each; bankruptcies don’t reduce your scores by 200 points; and removing a collection isn’t worth 25 points. What is weighted is the collection of negative information, as a whole.

Will paying off delinquent debts increase your credit score? Probably not. Still, it’s better to have fewer negative items on your report. To see the real score improvement, however, you’ll have to wait until the negative items are all gone or have aged off.

John Ulzheimer is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO and Equifax, John is the only recognized credit expert who actually comes from the credit industry. He is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a Contributor for the National Foundation for Credit Counseling. Follow him on Twitter »

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